Moneyball without the ball

Posts from the ‘Macro’ Category

I have spent much of my weekend researching the state of the Natural Gas market. In this post I am going to outline what I’ve learned and draw some tentative conclusions.

My interest in natural gas was piqued after the abnormally cold March that we’ve had and the coinciding decline in natural gas storage to below the 5 year average.

Subsequently, after reading an article posted by @Dedwardssays on his blog and a couple of articles on Seeking Alpha, I took a position in Gastar Exploration (GST). At the same time I added a call position in Exco Resources (XCO). Since then I have added a small position in WPX Energy (WPX), which appears to have had a large Niobrara discovery in the Piceance Basin. I also, of course, have held a position in Equal Energy (EQU) for the last number of weeks. I am actively looking for undervalued natural gas biased companies producing the in the lower 48. Read more

My investment strategy is to invest in small and often illiquid companies. This is where I have the greatest advantage. I am willing to spend time investigating names that very few others have even heard of. I have my doubts that there are more than a few handfuls of investors in the world that have spent the number of hours I have on Community Bankers Trust (BTC) or Rurban Financial (RBNF).

Investing in micro/nano/nonexistent cap companies gives me the opportunity to take advantage of what can sometimes be large price discrepancies. But it also has its drawbacks. In particular, because the companies are illiquid, I often cannot get out quickly once the tide has turned.

While I try to hedge this risk with due diligence, there is another aspect that cannot be mitigated with company specific research. In particular, when the macro becomes trump, these little stocks can become very difficult to unload.

I am not very good at holding tight through thick and thin. Perhaps I am a child of 2008 where I learned the rather significant lesson that buying and holding because the business is sound is not always a preferable strategy. In addition to the money and time lost by holding on, there is the mental toll that it takes. I hate to use cliches, but the one that fits well here is that it is better to live to fight another day.

I went back and reviewed some of my past posts on the macro-scene. I haven’t written very much about the macro-environment since my post “It’s a bull market“. In that post I outlined that while I remained wary of the long-term conditions in Europe and was concerned that the LTRO was only short-term panacea that would eventually be overcome by a tide of falling economic data, that the bottom-line was liquidity, which was abundant, and as far as stocks go that tends to trump all:

The underlying condition right now is one of liquidity. It is not the intent of this blog to philosophize (too much) on the eventual consequences of such liquidity. There are plenty of folks, like the wonderful Ms. Park, who are already describing those consequences eloquently. The intent here is to try to evaluate those conditions clearly, and to describe how I am acting to capitalize on those conditions.

Portfolio Performance

More on my Tepper moment

In a response to my post Yesterday’s David Tepper Moment, the comment was made that the original David Tepper moment came after stocks had already moved quite a bit and that, if this was to be another David Tepper moment, it would be because we are far closer to the top than to the bottom. The comment was directly especially at gold stocks.

This made me think twice. As I remembered it the months after the original Tepper moment were some of the best for my portfolio.

Of course it was possible that I was re-imagining history in the most flattering way. Rather than take my memory on its word I decided to go back and check the stats.

2010-2011 Portfolio Holdings

As it turns out, the 5 months following David Tepper’s comments were very good for my portfolio. They were also fairly good months for stocks as a whole. The S&P returned 13% over that period. Read more

Portfolio Performance

Portfolio Composition

Letting Go…

The occupation of investing is really one of evaluating risk. If you run a large institutional fund or a hedge fund or some other large sum of money, you perform this evaluation on a formal basis, giving its conclusions a formal sounding name like risk adjusted return or something of the like. If you are an individual investor your process is much more informal, your conclusions are often not written down (though a blog helps in this respect), but nevertheless you are continually going through the same basic process of evaluating the potential risk against its potential return.

I try to eliminate risk through exhaustive research of the companies I invest in. That elimination process involves getting up at five in the morning on weekends and spending hours readings through 10-Q reports and MD&A’s. It involves staying up late on week nights listening to conference calls and reading industry publications. All this effort is done in the attempt to understand what makes each particular business tick, and to understand if the fundamentals of that business are improving in such a way that value is about to be realized.

I find this to be time well spent. On the one hand I enjoy the investigative process. On the other, it is profitable. I am often able to narrow my focus to sectors that should experience positive fundamentals, and then to further narrow my focus to companies within those sectors that have competent management teams and solid assets that can deliver on a consistent basis. Whether the sector is mining or mortgages, paper or potash, banking or bitumen, it makes little difference to me. Given the time I can understand the business and develop a thesis to invest or not, and more often than not I am right.

In the 1990s and in the early part of this decade that was all you needed to do to consistently beat the market. You could do the work, pick good companies, understand the industry trends and wait for it to play out. It was a simple time.

Nowadays however, following that recipe in a vaccuum can you leave you without a leg to stand. The market today is analogous to playing a hand of cards where within the deck lies a single trump card that if played automatically will lose the hand for you. You can manage the cards you are dealt the best you can, do your darnest to evaluate the probabilities and make the best risk adjusted decision, but if that trump card is played you will lose it all.

That trump card was the US banking system in 2008 and it is the European sovereign system now. In either case the details differ, but the trump-like nature is essentially the same. The risk is systemic, the probability of that risk occuring is unknown, the outcomes of that risk impossible to quantify. Whenever you play a hand in the market these days you put yourself in danger of the consequences that the risk happens to be realized while your money is still on the table.

Because this is a risk that is so difficult, perhaps impossible, to understand, there is no way to hedge against it. I have yet to hear anyone, expert or otherwise, offer up a coherent and definitive conclusion on what to expect if Greece exists the Euro. Do markets open down 10% and continue to fall? Is it a non-event and an opportunity to buy? Is Greece this years Bear Stearns, to be followed by a few months of a false reprieve before the big one hits, perhaps it being Spain that takes on the role of Lehman this time around.

There was an excellent conference call held by Donald Coxe this week. During the call Coxe laid out the situation in Europe as well as anyone has. It appears to be coming to a head. More and more what we are seeing is that people, organizations and banks are making adjustments on the assumption that the Eurozone will not hold. Banks in the Eurozone are frantically trying to tie their loans to countries that may be forced to leave by getting financing from within those countries rather than abroad. Assuming there is an exit, the potential for a true global financial crisis is great if it is not an orderly one. Along with that would very likely come a global recession.

While it is not clear whether Greece will leave this week, next week or next month, it has become more clear that they will indeed leave eventually.

What is unclear is how such an event will ripple through the system. To provide a few examples, consider the following:

Right now the Eurozone countries run deficits with one another. Primarily Germany runs massive surpluses against southern periphery deficits. These imbalances are currently tallied in something called the TARGET2 mechanism. Target2 is essentially a way of transferring funds to countries (like Greece and Spain) that are running current account deficits so that those countries don’t run out of money. As long as all the countries are in the Eurozone these liabilities are just a paper trail between the individual Euro nation central banks and the ECB. However if a country with a large Target2 liability leaves the Eurozone, suddenly that liability needs to be paid back (the ultimate owner of the liability is the ECB). But will it be paid back? If it isn’t the ECB will take a big hit to its capital, potentially one that is big enough to cause the Central Bank to run out of capital completely. What happens when a Central Bank runs out of capital? I don’t think anyone really knows. Without a doubt it will be damning to confidence at the least.

What exactly is going to happen to Greece (or a little later, to Spain) if they leave the Euro and stop receiving funding from the rest of the Eurozone? The reason Greece is able to make basic payments such as salaries, pensions, drug and medical benefits, is because of the inflow of money from outside the country. If that inflow stops, what happens to the country? Does it devolve from borderline chaos to complete chaos? You have to wonder.

There are pension funds and insurance companies and other large entities that perform basic public services that likely have large balances of periphery debt. I was listening to the Goldman Sachs Insurance conference before bed last night. William Berkley, who is the CEO of the William Berkley Corporation, gave a fascinating talk about the industry. Most interesting perhaps is that Berkley believes that the biggest source of upside in the insurance industry over the next 24 months is likely to come from the failure of one or more of the large insurance giants in Europe. He gave it a 50/50 chance of happening. The reason he expects it to happen is because he is fairly certain that these companies are holding the bag on a large amount of peripheral sovereign and corporate debt. If this doesn’t scare you, it should. While 2008 began with the crisis of Lehman, it was amplified and extended by the crisis of the insurer AIG. Had AIG not been dealt with, that crisis could have been far worse.

What will bond holders of Spanish, Portugese, and Irish debt do in response? You always have to remember that, as Donald Coxe has described, the situation is existential. What that means is that the perception of weakness is weakness, and it will breed weakness. Will a Greek exit destroy the perception of Spain to such a degree that it becomes inevitable they will leave to? Do Spanish bond rates skyrocket in response?

Look, I am not an expert on the Eurozone or the consequences of a break-up. I’m just throwing out these ideas to highlight the complexity of situation and to illustrate how it is basically impossible for any of us to make a legitimate assessment of it. What it means to our investments is anybody’s guess.

Lighten Up

All I think I can do in a situation like this is to get smaller. Take on less risk, don’t take too many chances, wait for it to play out one way or another before wading in too far. Remember that even after Lehman went bankrupt, it took a few days for the market to recognize the consequences that were about to be felt. I don’t think this was because the market was ignoring those consequences so much as that no one really knew what they were until they started to happen. Same considerations this time around. It could be Y2K all over again. It could be Lehman all over again. We will just have to wait and see.

As an individual investor you are at many disadvantages. You don’t have access to the research, you don’t have access to the capital, you don’t have the range of strategic alternatives (hedging, taxes, etc) that a larger investor would be privy too. But the one advantage that you have as an individual investor is your ability to act quickly and to the extreme. A mutual fund, pension fund or hedge fund would have a lot of difficulty going to all cash, both from a logistical and a performance perspective. As an individual you answer to no one but yourself. You generally can cash out with little to no movement of the underlying stock price. If things get hairy, you have a legitimate choice as to whether or not to wait it out until they aren’t anymore.

Such is even more the case for my particular circumstance. The reality of chasing above market returns is that I am constantly venturing into areas that are volatile. Such is the case with gold stocks, oil stocks, even to an extent with the mortgage servicing stocks and smaller banks. These companies trade up and down to a greater extent than the market. Whether the fundamentals dictate it or not they will move down hard if the general market moves down. There is no amount of analysis that I can do to mitigate or prevent this. I can only accept this consequence as the likely reality, and plan accordingly.

I completely sold out of Gramercy Capital, Bank of Commerce Holdings, and Shore Bancshares in the last two weeks. I lightened up on the rest of my holdings by 10-20%. I ended this week with a little less than 30% cash. I plan to raise that cash level to 50% in the next week or two.

I would have an even higher cash level already, except that I have also entered into two short term positions as well. OceanaGold and Mart Resources. My thesis for OceanaGold is that the situation for the gold stocks appears to be turning. There have been a number of days where the stocks have outperformed the bullion, and there was even one day were gold was down substantially while many of the large cap mining stocks were up. This appears to me to be the start of something. OceanaGold remains one of the cheapest gold producers out there. It is by no means the most efficient producer, and thus it has also been beaten down substantially during this bear market in gold shares. I bought some shares at $1.80 simply on the notion that if this is a turn in gold stocks, OceanaGold should see some outsized gains as it recovers the ground it lost. If gold weakens further or if the gold stocks resume their downward trend, I will bail quickly.

Mart Resources is purely an event driven purchase. I own Mart in another broker managed account already and so I follow the story closely, but have never owned it in the account I track here so I don’t talk about it much. The company has two news events that I suspect are going to occur shortly. The first is the potential for an announcement of a dividend. I believe that such an announcement could result in a significant pop in the stock, as it gives credibility to what is otherwise looked on warily as a Nigerian story. The second is a pipeline deal with Shell, which would allow Mart to increase their production, perhaps substantially, and allow the brokerages that follow the story to up their targets based on larger 2013 volumes. Again, I am looking for an event to occur in somewhat short order, but I am not holding this stock for the long run. If the events in Greece take a turn for the worse, I plan to cut and run.

I come back to the quote I gave last week from Peter Bernstein. I think this is something worth repeating at a time like this:

The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive.

We live in impossible to understand times. You have to accept your own limits of knowledge and simply walk away from the table. Will I miss opportunities by having such a high level of cash? Quite possibly. But you can’t chase shadows. You have be a prudent manager of risk.

I’m can be slow to understand the implications of things. I don’t immediately see what in retrospect should be obvious. Instead I have to get people to spell things out for me before I get it.

I think this is partially a consequence of not being able to spend as much time thinking about the world as I need to. I have a job, I have a family and so I really don’t get a chance to sit down and work out all the potential impacts on a regular basis.

I’ve been looking at some private equity stocks lately, trying to understand them better and determine whether they are buys. As part of this research I stumbled upon a market commentary from Michael Novogratz, a principle at Fortress Investment Group. He crystallized for me why we are seeing the carnage we are in the markets (you have to wait until about 4 minutes in).

The key moment in the interview for me was when Novogratz spelled out that the Greek election was a game changer. If Greece leaves the Euro it is, in his words, a Lehman moment. If they leave, we don’t know for sure who owes who what or whether they can pay it back or if the assets and liabilities of any particular entity are going to balance out. Novogratz is saying that Greece could breed the sort of counter-party uncertainty that could cause credit markets to seize.

That’s when I suddenly got it. Its not that anyone can say with certainty that its going to end well or end badly. Novogratz himself said that the ECB and the Europeans governments have been preparing for a Greek exit for months. Its possible that they have worked out all the contingencies. But at the end of the day no one really knows. If Greece leaves it all goes out the window. You are really just guessing to bet what happens next.

Just to throw out some of the uncertainties, there is the effect of funds and banks with mixed liabilities of Euro’s and Drachmas’. There are the TARGET2 balances between Greece and other Eurozone countries that now become debt. There is the strange consequence that a Greek exit destroys all the capital of the ECB. There are the cross-border balances of companies that trade across the Eurozone. There is the deep recession in Greece that results. There is the investor response to Portugal, Italy and Spain sovereign debt. There are simply a lot of moving parts and it is perhaps impossible to estimate how they all play out.

It has the same flavour of uncertainty as Lehman did. And one thing that I learned from Lehman is that the decision makers know far less about the consequences then I thought they did. They aren’t that much smarter than the rest of us. Nobody knew what was going to happen when they let Lehman go until stuff started to happen after they let it go. I think its the same thing with Greece.

Today I raised 20% cash. I just sold a bit of everything, and I sold all of Gramercy Capital (GKK) because I wasn’t sure about it anyways. It helped that gold stocks rallied. It hurt that PHH and Newcastle had bad days. Maybe this is a terrible time for it. We could rally because we are so oversold. But I feel like I have no choice. Now that it makes sense to me it seems like too much risk. I want to get back to at least 50% cash by the Greek election or until there is a resolution that makes it clear Greece is staying.

Quite often these days I feel like I am playing a game of cat and mouse and I am the mouse. I sneak out of my hole and buy a few stocks that look to me like they are cheap, and I hope that I can make some money with these stocks and get back to my hole in the wall before Europe the cat comes into the room and raises its own form of hell.

This weekend I read another terror inducing installment about Europe from John Mauldin. What I appreciate about Mauldin’s pieces is that they actually delve into the numbers involved. I find it difficult to wrap my head around just how bad it is without getting into the numbers that demonstrate that badness. Of course once you do get into the numbers, it becomes clear that the numbers don’t add up and that, at some point, more numbers are going to have to come from somewhere. It also becomes clear that if no more numbers do come from somewhere (ie. the ECB doesn’t create any new numbers out of thin air) then the numbers in my portfolio are going to be smaller numbers than they are right now.

Such is this game of cat and mouse.

One new number that I learned from the piece and thought worth mentioning was that of the Spanish banks non-performing assets. According to Mauldin non-performing assets are about 20% of assets on average. He actually says capital in the report but I am pretty sure he means assets because 20% of capital is really nothing terrible in the grand scheme of things. But 20% of assets is and so that scared me quite a bit. But it seemed like such a high number that I thought I should get it from another source and the best source for all things Europe remains FT Alphaville. They came through once again with the following chart:

As an aside I wonder if Mauldin looked at this same graph but got the left and right axis mixed up. Right is unemployment, and it is indeed at 20% plus. Left is bad loans, and they are at a little over 8%. 8% is less than 20% but 8% is still not very good. Especially when its the average of all the banks. And extra-especially when the trend seems to have taken on the look of a hockey stick.

So regardless of whether Mauldin has his numbers right or not, they still don’t add up without help from the ECB. That was the basic point of Mauldin’s article this week. It basically still comes down to a stark choice between the 3 alternatives described in this old Edward Harrison article that I have brought up in the past. Harrison stated those three alternatives as being:

Monetization

Default

Break-up

When Harrison wrote his piece in late 2010 he figured the response would be some combination of default and monetization. He has since tweaked his view with the addendum that Greece will likely have to leave the Eurozone, so now we have a combination of all three. But monetization has always been the expected route to get through most of the angst, as it is in the easiest one.

Back to Mauldin, he points out that there are signs that the Germans are warming up to the idea of monetization. There was news this week from the German Bundesbank that the German are expecting (read: grudgingly accepting) higher rates of inflation. They expect this because they anticipate that higher rates will be necessary to stabilize the Eurozone. That sounds an awful lot like “we realize that Spanish bonds are going to go back up through the roof if we don’t get the ECB to continue their paper money patch job of the hole in it.”

Anyways that’s what it sounds like, and if its true its good in the short term because if they do then the cat will leave the room for a while and I can come out and actually make some money instead of being on a rollercoaster ride where all I really need to do in the morning is watch CNBC and check the Spanish stock market quote to know whether my portfolio of regional banks, mortgage originators and servicers, junior gold stocks and the odd oil stock, all of which have virtually no business is Spain, will be up or down. It gets tiresome.

So I welcome another respite from the ECB. I would only ask that they do it sooner rather than waiting until the world is back on the precipice as it was in late November. These last two months haven’t been a lot of fun.

I put a lot of emphasis on the Weekly Leading Index published by the Economic Cycle Research Institute. The index is a leading indicator of US economic growth. The index and its smoothed annualized growth rate have both turned up recently.

Presumably this suggests an improving economy. Yet the ECRI has been sticking to a prediction that the US economy is going to fall back into a recession.

Why?

I was reading through the ECRI’s publically available articles trying to find out why when I ran into this article. It describes a problem that has developed with the seasonal adjustment algorithms. It seems that the economic collapse that followed Lehman Brothers in 2008-2009 has led to a skew in the adjustment that is being made. Many of the seasonal adjustment algorithms are interpreting the downturn that occurred in Q4 2008 – Q1 2009 as a seasonal event that should be adjusted for.

Most data, both public and private, are seasonally adjusted. But the nature of the Great Recession seems to have had an unexpected impact on the statistical seasonal adjustment algorithms that are hard-wired to detect when the seasonal patterns evolve and change over the years. This is normally a good thing, but when the economy fell off a cliff in Q4/2008 and Q1/2009, it was partly interpreted by these procedures as a lasting change in seasonal patterns. So, according to these programs, data from Q4 and Q1 would be expected thereafter to be relatively weak, and therefore automatically adjusted upwards. Our due diligence on this subject indicates a widespread problem, resulting in many recent economic headlines being skewed to the upside.

The article was written in mid-March but as recent as last week the ECRI remained behind its conclusions and their conviction that the pick-up in growth is illusory. This SeekingAlpha article quoted Lakshman Achuthan (who is the chief economist and spokesman for the ECRI) recentlyas saying that year over year (yoy) growth, which would not be distorted by the 2008-2009 numbers, is not improving.

Please note that PCI growth yoy is still -2.2% and even q-o-q is -4.9%… With yoy growth in all the coincident indicators (GDP, industrial production, personal income and sales) all staying in cyclical downturns, and yoy payroll job growth, which had been the only holdout, now rolling over — as we had predicted a few weeks ago — it’s pretty clear that for now U.S. economic growth is worsening, not improving.

The rub is that the data we have been looking at from January through March may be overly optimistic. It is being overly adjusted to the high side. Now that we are into April, that is about to end.

The data isn’t great

Indeed we are seeing something like that in the recent numbers. The monthly jobs report was a big disappointment. The jobless claims number that came out last week spiked to 380,000.

Home sales, which to me would be the true sign of a pick-up in the economy, remain depressed.

Add to this the fact that gasoline prices are about the only thing that have recovered to pre-recession highs.

What does it mean?

The situation feels to me like another false start. To use the phrase coined by John Maudlin, we are in for more muddling through. Low growth rates, low interest rates; maybe the ECRI will prove to be right and we will dip into another recession.

As for my portfolio, I am of the mind that I am mostly in stocks that should perform well in this environment.

Given the bleak outlook, gold and gold stocks should do well. Of course gold stocks have done anything but well lately. I have to remind myself of the volatility of these stocks, how they can bounce up and down like a yo-yo and turn on a dime. I think that as it becomes more clear that the skies remain grey and the horizon dark, the gold stocks should recover. I am certain that the reason we have not seen a breakdown in the price of gold itself is because there is smart money out there that sees the same picture I am drawing.

The mortgage servicers, Newcastle, Nationstar, and PHH, should hold their own in this environment. Servicing revenues are not dependent on an uptick in home sales to the same extent as other housing related businesses. Interest rates remain at such low levels that these companies continue to accumulate incredible assets (in the form of new servicing rights) that will outperform in years to come.

The regional banks are a bit of a tougher choice. However when I look at many of the regionals, they remain below their price level before the European shock in the summer. The US economy may not be getting that much better, but it is slowly healing, and to see these stocks at lower levels is, in my opinion, a disconnect.